On January 31, 2013, the Department of Housing and Urban Development (HUD) issued a new rule for all FHA borrowers. According to HUD Mortgagee Letter 2013-05, applicants with credit scores below 620 and debt-to-income ratios above 43% must undergo a stricter form of manual underwriting, prior to approval. This could narrow the eligibility window and put financing out of reach for some borrowers.

These days, FHA loans are one of the most popular financing tools for home buyers. They are especially popular among first-time home buyers. A 2012 survey found that more than half of all first-time purchasers used the FHA program when buying a house. This is primarily due to the lower down-payment requirements and easier qualification criteria associated with these loans.

But FHA mortgages may be harder to come by in 2013, as the result of some new rules for credit scores and debt ratios. Here’s what you need to know:

Current Rules for FHA-Insured Mortgage Loans

The FHA does not lend money to home buyers. Rather, they insure the loans made by lenders in the private sector. The money comes from the bank, as with any other type of mortgage. Thus, they are government-backed mortgage loans. While the FHA manages the program, the lender has the final say on whether or not a borrower is qualified.

Credit scores are one of the most important criteria for FHA loans, and mortgages in general. Consumer credit scores are like a report card of past borrowing activity. These three-digit numbers are derived from information found within a consumer’s credit report. The reports contain a detailed history of current and past credit card accounts, personal loans, payment histories, delinquencies, and other financial activities.

A low score makes it harder to qualify for a home loan, while a higher score makes it easier to get approved.

There are two official credit-score cutoffs for FHA loans. They are 500 and 580. Borrowers need a 500 or higher just to be eligible for the program.* Additionally, borrowers need a 580 or higher to qualify for the 3.5% down-payment option, which is the biggest benefit of the FHA program.

* The official cutoff for program eligibility is 500. But it’s unlikely a borrower would actually qualify for a loan at that level. Most lenders today require scores of 600 or above for FHA financing. These are known as ‘overlays.’

Officials with the Department of Housing and Urban Development (HUD), which oversees the FHA program, recently announced some additional changes to these program guidelines.

Extra Scrutiny for Borrowers in the 580 – 620 Zone

The FHA is struggling to survive. Mounting financial losses have wiped out the agency’s financial reserves. A congressional mandate requires the agency to maintain capital reserves equal to 2% of its total loan guarantees, or above. It dipped below that level three years ago, when the foreclosure crisis came to a head. Last year, the agency’s reserves stood at 0.2% of all loan guarantees. According to the latest report, they have now fallen to -1.4%.

HUD is trying to staunch the bleeding. Over the last couple of years, they have implemented a number of program changes designed to slow the FHA’s losses (in the short term) and rebuild its capital reserves (over the long term). The latest change has to do with credit scores and debt-to-income ratios. It will take effect in 2013.

Republican Sen. Bob Corker of Tennessee is one of many in Congress who are pressing for changes to the FHA program. In exchange for such reform, Corker said he will support Carol Galante’s confirmation as the next commissioner of the Federal Housing Administration. (Galante stepped in as acting commissioner in 2011, when David H. Stevens left to join the Mortgage Bankers Association.)

Here is an excerpt from a letter sent from Carol Galante to Bob Corker on December 18, 2012:

“FHA … will require borrowers with scores below 620 to have a maximum debt-to-income ratio no greater than 43 percent in order for their loan applications to be approved through FHA’s TOTAL Scorecard … If a borrower’s DTI exceeds 43 percent, lenders will be required to manually underwrite the loan.”

The TOTAL Scorecard is an automated system that helps lenders determine if a borrower is qualified for the government-backed mortgage program. In other words, it’s part of their automated underwriting system. Going forward, borrowers with credit scores below 620 will receive additional human scrutiny during the underwriting process. The underwriter must find — and document — some kind of compensating factor, such as a large down payment, in order to approve the borrower.

In plain English: Borrowers with credit scores below 620 will set off a red flag in the FHA’s computerized screening program. At that point, a mortgage underwriter must step in to make sure they don’t have too much debt. If the borrower’s combined debts use up more than 43% of his or her monthly income, the loan may fall through. However, if the underwriter finds some positive factors to offset the higher debt ratio, the loan may still go through.

Note: This is a preliminary report on a developing story. We expect to learn more about the new FHA credit-score requirements over the coming weeks. This story may be updated in 2013, as additional details emerge.